Thursday, October 14, 2010

The September report on Producer Prices shows no sign of deflation, but rather an ongoing rise in prices. Over the past year, the Producer Price Index rose 4%, while the core rate rose 1.5%; the core rate has actually risen at 2% annualized rate for most of this year. Both are registering more inflation (2-4%) in recent years than the 1.6% average annual rate of producer price inflation we had in the disinflationary 1990s. Since the Fed first started easing policy in earnest in 2001, there has been a notable pickup in the pace of inflation at the producer level that continues to this day. Not coincidentally, commodity prices have in general been very strong for past 9 years. With commodity prices continuing their rise, we have every reason to expect that producer inflation will remain elevated—and possibly rise—in coming months.

This is not an environment that begs for further quantitative easing. On the contrary, this report should be high on the list of reasons why QE2 is not necessary at this time.

I suspect that if the FOMC were to announce next month that they remain committed to doing whatever it takes to ensure that the economy is expanding and deflationary risks are minimal, but that it thinks the economy is healthy enough not to need further QE at this time, that the market might be briefly disappointed. But I also suspect that after a selloff, reason would take over and risk prices would again rise. Nobody wants to see the Fed try to push inflation higher. Nearly everyone has a stake in the dollar retaining its purchasing power. Higher interest rates and a stronger economy are in everyone's best interest.